Why a policy on related party transactions makes good business sense

12 September 2011

Adopting a related party transactions policy, with supporting protocols and procedures, will help to identify and deal with related party transactions within the corporation. Ultimately, this will reduce the risk of breaching the Corporations Act 2001 (Cth) or ASX Listing Rules (if relevant) and will protect shareholders' interests. This article examines the key benefits that can flow to a public company from adopting a related party transactions policy and addresses some of the issues that the policy should cover.

Under the Corporations Act, public companies and their controlled entities must not undertake a transaction with a 'related party' unless it falls into one of the exemptions specified in the Act or it is approved by shareholders.

Despite the comparative frequency of related party transactions, few Australian companies have adopted policies setting out a procedural framework for these transactions and providing guidance for processing them. This is surprising, given the extensive press coverage of related party transactions, the infamy of certain proceedings involving related party transactions (see HIH Insurance Ltd (in prov liq); Australian Securities and Investments Commission v Adler [2002] NSWSC 171) and the recent release by ASIC of its updated Regulatory Guide 76Related Party Transactions, which sets out guidance for a company undertaking a related party transaction.

For US companies, the concept of a related party transactions policy is not new. Companies listed on the SEC are required to adopt related party transactions policies under Regulation S-K of the Securities Act 1933. Australian companies could benefit from following the example set by their US counterparts.

Why should a public company adopt a related party transactions policy?

A framework for decision making

Establishing a procedure and protocols to identify and process related party transactions encourages the correct application of the Corporations Act, the ASX Listing Rules (which contain their own rules for the approval of related party transactions), ASIC's guidance and case law.

It promotes the consistent application of the legal rules and enables individual employees to deal with related party transactions within a proper framework for decision making. The policy should be tailored to work within the company's governance framework and contain detailed advice and examples that are specific to the company and its related parties.

The protocols can include procedures for initial internal notification of a potential related party transaction, procedures for escalating consideration of the transaction to the board or management committee, and procedures for keeping a register of all related party transactions together with the relevant information concerning these transactions. That register can be invaluable in the event a transaction is ever called into question by ASIC or an interested party.

Clear identification of a related party

It is not always clear whether an entity is a related party of a public company. Directors, controlling entities, directors of controlling entities and their respective spouses are clear examples of related parties, but other categories can easily be overlooked.

A related party transactions policy can help to identify all the related parties of a company so that any related party transactions are given proper consideration. It should set out clear guidelines on who and what entities will be related parties and, more importantly, provide a list of the company's known related parties.

Clear definition of 'financial benefits'

Conferring a 'financial benefit' on a related party is a defining feature of a related party transaction. The term 'financial benefit' has a wide application, encompassing a multitude of potential transactions – such as transactions undertaken through interposed entities, informal agreements or agreements that have no binding force, and transactions that involve no 'cash' element.

A policy can help identify related party transactions that are less obvious by giving specific examples of financial benefits, tailored to the industry and the company. It can also list transactions that have in the past, or might in the future, constitute the giving of a 'financial benefit'.

Proper application and documentation of reliance on exemptions

A related party transaction can be undertaken by a public company, without shareholder approval, if it falls into one of the exemptions contained in the Corporations Act – most commonly the 'arm's length' exemption.

The 'arm's length' exemption permits companies to undertake transactions with related parties, provided the two parties are dealing on 'arm's length' terms. This exemption is sometimes applied without consideration of all the relevant factors or proper documentation of the underlying agreement or the determination that the transaction is at 'arm's length'.

Establishing a protocol for applying the arm's length exemption helps companies avoid two common pitfalls.

The first pitfall is the assumption that obtaining an independent valuation of a price paid in a related party transaction is enough to ensure the transaction is on arm's length terms. Price is just one factor to take into account to ensure a transaction is on arm's length terms. Other factors include negotiation of terms, warranties and indemnities, due diligence and exclusivity, to name a few. Regulatory Guide 76 also sets out the factors that ASIC expects to be taken into consideration when applying the 'arm's length' exemption.

The second pitfall is a lack of documentation. In some cases neither the actual related party transaction nor the determination that it is on arm's length terms is documented.

In the case of ASIC v Australian Investors Forum Pty Limited and Ors (No 2) [2005] NSWSC 267, Justice Palmer held that the payment of a management fee was not on arm's length terms. He said that a reasonable party dealing at arm's length would, as a matter of ordinary commercial prudence, insist on a contract in writing and an invoice properly detailing what services had been provided. He also observed that there was no record in the board minutes of any discussion concerning the payment of the management fee. This case showed the importance of documenting board considerations and having written agreements and proper invoices for work done when relying on the arm's length exemption.

Protocols that establish these practices can be enshrined in the policy to ensure the rules are properly applied.

More effective risk management

By promoting compliance with the provisions, a policy can manage the risk of a breach of the Corporations Act and the Listing Rules (if relevant).

Any person involved in contravening the related party provisions contravenes the Act and, if the involvement is dishonest, that person will be guilty of an offence. This liability extends to directors and officers and may also include legal and financial advisers.

Proper application of these rules helps directors to comply with their fiduciary duties. Directors, as fiduciaries, have a duty to avoid placing themselves in a position in which their own interests or their duties to someone else conflict with their duty to the company. These principles are reflected in the Corporations Act provisions, but may also have direct application where directors enter into related party transactions with their companies.

Protection of shareholder interests

The related party transactions chapter in the Corporations Act is 'designed to protect the interests of a public company's members as a whole, by requiring member approval for giving financial benefits to related parties that could endanger those interests.'

The establishment and application of a policy will promote this purpose and protect shareholders' investment in the company, by ensuring that all transactions the company enters into are for the benefit of the company, and by creating an environment where it is difficult to dishonestly or incorrectly apply the rules.

The broader policy

We have considered some of the main issues that should be covered in a related party transactions policy, but there are many other topics and issues that also warrant inclusion, such as disclosure of related party transactions and the conflict of interest principles. Often a related party transactions policy can be combined with a conflict of interest policy.